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Chair Janet L.

Yellen
At "Designing Resilient Monetary Policy Frameworks for the Future," a symposium
sponsored by the Federal Reserve Bank of Kansas City, Jackson Hole, Wyoming
August 26, 2016
The Federal Reserve's Monetary Policy Toolkit: Past, Present, and Future
The Global Financial Crisis and Great Recession posed daunting new challenges fo
r central banks around the world and spurred innovations in the design, implemen
tation, and communication of monetary policy. With the U.S. economy now nearing
the Federal Reserve's statutory goals of maximum employment and price stability,
this conference provides a timely opportunity to consider how the lessons we le
arned are likely to influence the conduct of monetary policy in the future.
The theme of the conference, "Designing Resilient Monetary Policy Frameworks for
the Future," encompasses many aspects of monetary policy, from the nitty-gritty
details of implementing policy in financial markets to broader questions about
how policy affects the economy. Within the operational realm, key choices includ
e the selection of policy instruments, the specific markets in which the central
bank participates, and the size and structure of the central bank's balance she
et. These topics are of great importance to the Federal Reserve. As noted in the
minutes of last month's Federal Open Market Committee (FOMC) meeting, we are st
udying many issues related to policy implementation, research which ultimately w
ill inform the FOMC's views on how to most effectively conduct monetary policy i
n the years ahead. I expect that the work discussed at this conference will make
valuable contributions to the understanding of many of these important issues.
My focus today will be the policy tools that are needed to ensure that we have a
resilient monetary policy framework. In particular, I will focus on whether our
existing tools are adequate to respond to future economic downturns. As I will
argue, one lesson from the crisis is that our pre-crisis toolkit was inadequate
to address the range of economic circumstances that we faced. Looking ahead, we
will likely need to retain many of the monetary policy tools that were developed
to promote recovery from the crisis. In addition, policymakers inside and outsi
de the Fed may wish at some point to consider additional options to secure a str
ong and resilient economy. But before I turn to these longer-run issues, I would
like to offer a few remarks on the near-term outlook for the U.S. economy and t
he potential implications for monetary policy.
Current Economic Situation and Outlook
U.S. economic activity continues to expand, led by solid growth in household spe
nding. But business investment remains soft and subdued foreign demand and the a
ppreciation of the dollar since mid-2014 continue to restrain exports. While eco
nomic growth has not been rapid, it has been sufficient to generate further impr
ovement in the labor market. Smoothing through the monthly ups and downs, job ga
ins averaged 190,000 per month over the past three months. Although the unemploy
ment rate has remained fairly steady this year, near 5 percent, broader measures
of labor utilization have improved. Inflation has continued to run below the FO
MC's objective of 2 percent, reflecting in part the transitory effects of earlie
r declines in energy and import prices.
Looking ahead, the FOMC expects moderate growth in real gross domestic product (
GDP), additional strengthening in the labor market, and inflation rising to 2 pe
rcent over the next few years. Based on this economic outlook, the FOMC continue
s to anticipate that gradual increases in the federal funds rate will be appropr
iate over time to achieve and sustain employment and inflation near our statutor
y objectives. Indeed, in light of the continued solid performance of the labor m
arket and our outlook for economic activity and inflation, I believe the case fo
r an increase in the federal funds rate has strengthened in recent months. Of co
urse, our decisions always depend on the degree to which incoming data continues

to confirm the Committee's outlook.


And, as ever, the economic outlook is uncertain, and so monetary policy is not o
n a preset course. Our ability to predict how the federal funds rate will evolve
over time is quite limited because monetary policy will need to respond to what
ever disturbances may buffet the economy. In addition, the level of short-term i
nterest rates consistent with the dual mandate varies over time in response to s
hifts in underlying economic conditions that are often evident only in hindsight
. For these reasons, the range of reasonably likely outcomes for the federal fun
ds rate is quite wide--a point illustrated by figure 1 in your handout. The line
in the center is the median path for the federal funds rate based on the FOMC's
Summary of Economic Projections in June.1 The shaded region, which is based on
the historical accuracy of private and government forecasters, shows a 70 percen
t probability that the federal funds rate will be between 0 and 3-1/4 percent at
the end of next year and between 0 and 4-1/2 percent at the end of 2018.2 The r
eason for the wide range is that the economy is frequently buffeted by shocks an
d thus rarely evolves as predicted. When shocks occur and the economic outlook c
hanges, monetary policy needs to adjust. What we do know, however, is that we wa
nt a policy toolkit that will allow us to respond to a wide range of possible co
nditions.
The Pre-Crisis Toolkit
Prior to the financial crisis, the Federal Reserve's monetary policy toolkit was
simple but effective in the circumstances that then prevailed. Our main tool co
nsisted of open market operations to manage the amount of reserve balances avail
able to the banking sector.3 These operations, in turn, influenced the interest
rate in the federal funds market, where banks experiencing reserve shortfalls co
uld borrow from banks with excess reserves. Before the onset of the crisis, the
volume of reserves was generally small--only about $45 billion or so.4 Thus, eve
n small open market operations could have a significant effect on the federal fu
nds rate. Changes in the federal funds rate would then be transmitted to other s
hort-term interest rates, affecting longer-term interest rates and overall finan
cial conditions and hence inflation and economic activity. This simple, light-to
uch system allowed the Federal Reserve to operate with a relatively small balanc
e sheet--less than $1 trillion before the crisis--the size of which was largely
determined by the need to supply enough U.S. currency to meet demand.5
The global financial crisis revealed two main shortcomings of this simple toolki
t. The first was an inability to control the federal funds rate once reserves we
re no longer relatively scarce. Starting in late 2007, faced with acute financia
l market distress, the Federal Reserve created programs to keep credit flowing t
o households and businesses.6 The loans extended under those programs helped sta
bilize the financial system. But the additional reserves created by these progra
ms, if left unchecked, would have pushed down the federal funds rate, driving it
well below the FOMC's target. To prevent such an outcome, the Federal Reserve t
ook several steps to offset (or sterilize) the effect of its liquidity and credi
t operations on reserves.7 By the fall of 2008, however, the reserve effects of
our liquidity and credit programs threatened to become too large to sterilize vi
a asset sales and other existing tools. Without sufficient sterilization capacit
y, the quantity of reserves increased to a point that the Federal Reserve had di
fficulty maintaining effective control over the federal funds rate.
Of course, by the end of 2008, stabilizing the federal funds rate at a level mat
erially above zero was not an immediate concern because the economy clearly need
ed very low short-term interest rates. Faced with a steep rise in unemployment a
nd declining inflation, the FOMC lowered its target for the federal funds rate t
o near zero, a reduction of roughly 5 percentage points over the previous year a
nd a half. Nonetheless, a variety of policy benchmarks would, at least in hindsi
ght, have called for pushing the federal funds rate well below zero during the e
conomic downturn.8 That doing so was impossible highlights the second serious li

mitation of our pre-crisis policy toolkit: its inability to generate substantial


ly more accommodation than could be provided by a near-zero federal funds rate.
Our Expanded Toolkit
To address the challenges posed by the financial crisis and the subsequent sever
e recession and slow recovery, the Federal Reserve significantly expanded its mo
netary policy toolkit. In 2006, the Congress had approved plans to allow the Fed
, beginning in 2011, to pay interest on banks' reserve balances.9 In the fall of
2008, the Congress moved up the effective date of this authority to October 200
8. That authority was essential. Paying interest on reserve balances enables the
Fed to break the strong link between the quantity of reserves and the level of
the federal funds rate and, in turn, allows the Federal Reserve to control short
-term interest rates when reserves are plentiful. In particular, once economic c
onditions warrant a higher level for market interest rates, the Federal Reserve
could raise the interest rate paid on excess reserves--the IOER rate. A higher I
OER rate encourages banks to raise the interest rates they charge, putting upwar
d pressure on market interest rates regardless of the level of reserves in the b
anking sector.
While adjusting the IOER rate is an effective way to move market interest rates
when reserves are plentiful, federal funds have generally traded below this rate
. This relative softness of the federal funds rate reflects, in part, the fact t
hat only depository institutions can earn the IOER rate. To put a more effective
floor under short-term interest rates, the Federal Reserve created supplementar
y tools to be used as needed. For instance, the overnight reverse repurchase agr
eement (ON RRP) facility is available to a variety of counterparties, including
eligible money market funds, government-sponsored enterprises, broker-dealers, a
nd depository institutions. Through it, eligible counterparties may invest funds
overnight with the Federal Reserve at a rate determined by the FOMC. Similar to
the payment of IOER, the ON RRP facility discourages participating institutions
from lending at a rate substantially below that offered by the Fed.10
Our current toolkit proved effective last December. In an environment of superab
undant reserves, the FOMC raised the effective federal funds rate--that is, the
weighted average rate on federal funds transactions among participants in that m
arket--by the desired amount, and we have since maintained the federal funds rat
e in its target range.
Two other major additions to the Fed's toolkit were large-scale asset purchases
and increasingly explicit forward guidance.11 Both were used to provide addition
al monetary policy accommodation after short-term interest rates fell close to z
ero. Our purchases of Treasury and mortgage-related securities in the open marke
t pushed down longer-term borrowing rates for millions of American families and
businesses. Extended forward rate guidance--announcing that we intended to keep
short-term interest rates lower for longer than might have otherwise been expect
ed--also put significant downward pressure on longer-term borrowing rates, as di
d guidance regarding the size and scope of our asset purchases.
In light of the slowness of the economic recovery, some have questioned the effe
ctiveness of asset purchases and extended forward rate guidance. But this critic
ism fails to consider the unusual headwinds the economy faced after the crisis.
Those headwinds included substantial household and business deleveraging, unfavo
rable demand shocks from abroad, a period of contractionary fiscal policy, and u
nusually tight credit, especially for housing. Studies have found that our asset
purchases and extended forward rate guidance put appreciable downward pressure
on long-term interest rates and, as a result, helped spur growth in demand for g
oods and services, lower the unemployment rate, and prevent inflation from falli
ng further below our 2 percent objective.12
Two of the Fed's most important new tools--our authority to pay interest on exce

ss reserves and our asset purchases--interacted importantly. Without IOER author


ity, the Federal Reserve would have been reluctant to buy as many assets as it d
id because of the longer-run implications for controlling the stance of monetary
policy. While we were buying assets aggressively to help bring the U.S. economy
out of a severe recession, we also had to keep in mind whether and how we would
be able to remove monetary policy accommodation when appropriate. That issue wa
s particularly relevant because we fund our asset purchases through the creation
of reserves, and those additional reserves would have made it ever more difficu
lt for the pre-crisis toolkit to raise short-term interest rates when needed.
The FOMC considered removing accommodation by first reducing our asset holdings
(including through asset sales) and raising the federal funds rate only after ou
r balance sheet had contracted substantially. But we decided against this approa
ch because our ability to predict the effects of changes in the balance sheet on
the economy is less than that associated with changes in the federal funds rate
. Excessive inflationary pressures could arise if assets were sold too slowly. C
onversely, financial markets and the economy could potentially be destabilized i
f assets were sold too aggressively. Indeed, the so-called taper tantrum of 2013
illustrates the difficulty of predicting financial market reactions to announce
ments about the balance sheet. Given the uncertainty and potential costs associa
ted with large-scale asset sales, the FOMC instead decided to begin removing mon
etary policy accommodation primarily by adjusting short-term interest rates rath
er than by actively managing its asset holdings.13 That strategy--raising shortterm interest rates once the recovery was sufficiently advanced while maintainin
g a relatively large balance sheet and plentiful bank reserves--depended on our
ability to pay interest on excess reserves.
Where Do We Go from Here?
What does the future hold for the Fed's toolkit? For starters, our ability to us
e interest on reserves is likely to play a key role for years to come. In part,
this reflects the outlook for our balance sheet over the next few years. As the
FOMC has noted in its recent statements, at some point after the process of rais
ing the federal funds rate is well under way, we will cease or phase out reinves
ting repayments of principal from our securities holdings. Once we stop reinvest
ment, it should take several years for our asset holdings--and the bank reserves
used to finance them--to passively decline to a more normal level. But even aft
er the volume of reserves falls substantially, IOER will still be important as a
contingency tool, because we may need to purchase assets during future recessio
ns to supplement conventional interest rate reductions.14 Forecasts now show the
federal funds rate settling at about 3 percent in the longer run.15 In contrast
, the federal funds rate averaged more than 7 percent between 1965 and 2000. Thu
s, we expect to have less scope for interest rate cuts than we have had historic
ally.
In part, current expectations for a low future federal funds rate reflect the FO
MC's success in stabilizing inflation at around 2 percent--a rate much lower tha
n rates that prevailed during the 1970s and 1980s. Another key factor is the mar
ked decline over the past decade, both here and abroad, in the long-run neutral
real rate of interest--that is, the inflation-adjusted short-term interest rate
consistent with keeping output at its potential on average over time.16 Several
developments could have contributed to this apparent decline, including slower g
rowth in the working-age populations of many countries, smaller productivity gai
ns in the advanced economies, a decreased propensity to spend in the wake of the
financial crises around the world since the late 1990s, and perhaps a paucity o
f attractive capital projects worldwide.17 Although these factors may help expla
in why bond yields have fallen to such low levels here and abroad, our understan
ding of the forces driving long-run trends in interest rates is nevertheless lim
ited, and thus all predictions in this area are highly uncertain.18
Would an average federal funds rate of about 3 percent impair the Fed's ability

to fight recessions? Based on the FOMC's behavior in past recessions, one might
think that such a low interest rate could substantially impair policy effectiven
ess. As shown in the first column of the table in the handout, during the past n
ine recessions, the FOMC cut the federal funds rate by amounts ranging from abou
t 3 percentage points to more than 10 percentage points. On average, the FOMC re
duced rates by about 5-1/2 percentage points, which seems to suggest that the FO
MC would face a shortfall of about 2-1/2 percentage points for dealing with an a
verage-sized recession. But this simple comparison exaggerates the limitations o
n policy created by the zero lower bound. As shown in the second column, the fed
eral funds rate at the start of the past seven recessions was appreciably above
the level consistent with the economy operating at potential in the longer run.
In most cases, this tighter-than-normal stance of policy before the recession ap
pears to have reflected some combination of initially higher-than-normal labor u
tilization and elevated inflation pressures. As a result, a large portion of the
rate cuts that subsequently occurred during these recessions represented the un
doing of the earlier tight stance of monetary policy. Of course, this situation
could occur again in the future. But if it did, the federal funds rate at the on
set of the recession would be well above its normal level, and the FOMC would be
able to cut short-term interest rates by substantially more than 3 percentage p
oints.
A recent paper takes a different approach to assessing the FOMC's ability to res
pond to future recessions by using simulations of the FRB/US model.19 This analy
sis begins by asking how the economy would respond to a set of highly adverse sh
ocks if policymakers followed a fairly aggressive policy rule, hypothetically as
suming that they can cut the federal funds rate without limit.20 It then imposes
the zero lower bound and asks whether some combination of forward guidance and
asset purchases would be sufficient to generate economic conditions at least as
good as those that occur under the hypothetical unconstrained policy. In general
, the study concludes that, even if the average level of the federal funds rate
in the future is only 3 percent, these new tools should be sufficient unless the
recession were to be unusually severe and persistent.
Figure 2 in your handout illustrates this point. It shows simulated paths for in
terest rates, the unemployment rate, and inflation under three different monetar
y policy responses--the aggressive rule in the absence of the zero lower bound c
onstraint, the constrained aggressive rule, and the constrained aggressive rule
combined with $2 trillion in asset purchases and guidance that the federal funds
rate will depart from the rule by staying lower for longer.21 As the blue dashe
d line shows, the federal funds rate would fall far below zero if policy were un
constrained, thereby causing long-term interest rates to fall sharply. But despi
te the lower bound, asset purchases and forward guidance can push long-term inte
rest rates even lower on average than in the unconstrained case (especially when
adjusted for inflation) by reducing term premiums and increasing the downward p
ressure on the expected average value of future short-term interest rates. Thus,
the use of such tools could result in even better outcomes for unemployment and
inflation on average.
Of course, this analysis could be too optimistic. For one, the FRB/US simulation
s may overstate the effectiveness of forward guidance and asset purchases, parti
cularly in an environment where long-term interest rates are also likely to be u
nusually low.22 In addition, policymakers could have less ability to cut short-t
erm interest rates in the future than the simulations assume. By some calculatio
ns, the real neutral rate is currently close to zero, and it could remain at thi
s low level if we were to continue to see slow productivity growth and high glob
al saving.23 If so, then the average level of the nominal federal funds rate dow
n the road might turn out to be only 2 percent, implying that asset purchases an
d forward guidance might have to be pushed to extremes to compensate.24 Moreover
, relying too heavily on these nontraditional tools could have unintended conseq
uences. For example, if future policymakers responded to a severe recession by a

nnouncing their intention to keep the federal funds rate near zero for a very lo
ng time after the economy had substantially recovered and followed through on th
at guidance, then they might inadvertently encourage excessive risk-taking and s
o undermine financial stability.
Finally, the simulation analysis certainly overstates the FOMC's current ability
to respond to a recession, given that there is little scope to cut the federal
funds rate at the moment. But that does not mean that the Federal Reserve would
be unable to provide appreciable accommodation should the ongoing expansion falt
er in the near term. In addition to taking the federal funds rate back down to n
early zero, the FOMC could resume asset purchases and announce its intention to
keep the federal funds rate at this level until conditions had improved markedly
--although with long-term interest rates already quite low, the net stimulus tha
t would result might be somewhat reduced.
Despite these caveats, I expect that forward guidance and asset purchases will r
emain important components of the Fed's policy toolkit. In addition, it is criti
cal that the Federal Reserve and other supervisory agencies continue to do all t
hey can to ensure a strong and resilient financial system. That said, these tool
s are not a panacea, and future policymakers could find that they are not adequa
te to deal with deep and prolonged economic downturns. For these reasons, policy
makers and society more broadly may want to explore additional options for helpi
ng to foster a strong economy.
On the monetary policy side, future policymakers might choose to consider some a
dditional tools that have been employed by other central banks, though adding th
em to our toolkit would require a very careful weighing of costs and benefits an
d, in some cases, could require legislation. For example, future policymakers ma
y wish to explore the possibility of purchasing a broader range of assets. Beyon
d that, some observers have suggested raising the FOMC's 2 percent inflation obj
ective or implementing policy through alternative monetary policy frameworks, su
ch as price-level or nominal GDP targeting. I should stress, however, that the F
OMC is not actively considering these additional tools and policy frameworks, al
though they are important subjects for research.
Beyond monetary policy, fiscal policy has traditionally played an important role
in dealing with severe economic downturns. A wide range of possible fiscal poli
cy tools and approaches could enhance the cyclical stability of the economy.25 F
or example, steps could be taken to increase the effectiveness of the automatic
stabilizers, and some economists have proposed that greater fiscal support could
be usefully provided to state and local governments during recessions. As alway
s, it would be important to ensure that any fiscal policy changes did not compro
mise long-run fiscal sustainability.
Finally, and most ambitiously, as a society we should explore ways to raise prod
uctivity growth. Stronger productivity growth would tend to raise the average le
vel of interest rates and therefore would provide the Federal Reserve with great
er scope to ease monetary policy in the event of a recession. But more important
ly, stronger productivity growth would enhance Americans' living standards. Thou
gh outside the narrow field of monetary policy, many possibilities in this arena
are worth considering, including improving our educational system and investing
more in worker training; promoting capital investment and research spending, bo
th private and public; and looking for ways to reduce regulatory burdens while p
rotecting important economic, financial, and social goals.
Conclusion
Although fiscal policies and structural reforms can play an important role in st
rengthening the U.S. economy, my primary message today is that I expect monetary
policy will continue to play a vital part in promoting a stable and healthy eco
nomy. New policy tools, which helped the Federal Reserve respond to the financia

l crisis and Great Recession, are likely to remain useful in dealing with future
downturns. Additional tools may be needed and will be the subject of research a
nd debate. But even if average interest rates remain lower than in the past, I b
elieve that monetary policy will, under most conditions, be able to respond effe
ctively.
1. The June 2016 Summary of Economic Projections (SEP) is an addendum to the min
utes of the June 2016 FOMC meeting and is available on the Board's website at ww
w.federalreserve.gov/monetarypolicy/files/fomcminutes20160615.pdf. Return to tex
t
2. The confidence interval equals (subject to a lower bound of 12.5 basis points
) the median SEP path for the federal funds rate plus or minus average root mean
squared prediction errors (RMSPEs) of the three-month Treasury bill rate, for h
orizons from zero to nine quarters ahead, based on forecast errors made over the
past 20 years. Average RMSPEs are calculated as the mean of the RMSPEs of the f
ollowing forecasters, subject to availability for the horizon in question: the F
ederal Reserve Board staff (Greenbook/Tealbook), the Administration, the Congres
sional Budget Office, the Blue Chip consensus forecast, and the Survey of Profes
sional Forecasters. Differences in predictive accuracy among these forecasters a
re not statistically significant. For more information on the general methodolog
y used to construct confidence intervals using historical forecasting errors, se
e David Reifschneider and Peter Tulip (2007), "Gauging the Uncertainty of the Ec
onomic Outlook from Historical Forecasting Errors (PDF)," Finance and Economics
Discussion Series 2007-60 (Washington: Board of Governors of the Federal Reserve
System, November). Return to text
3. Open market operations at the time were primarily repurchase agreements based
on Treasury securities, with primary dealers as counterparties. Return to text
4. Reserves of depository institutions include vault cash and balances maintaine
d with Federal Reserve Banks. Excess reserves are the reserves held over and abo
ve required reserves. See the Board's webpage "Reserve Requirements" at www.fede
ralreserve.gov/monetarypolicy/reservereq.htm. Return to text
5. Prior to the financial crisis, the size of the Fed's balance sheet was about
$900 billion. Assets consisted almost entirely of Treasury securities. Liabiliti
es included currency held by the public and a relatively small volume of reserve
balances. For more on the Fed's balance sheet, see www.federalreserve.gov/monet
arypolicy/bst_fedsbalancesheet.htm. Return to text
6. For information on the Federal Reserve's credit and liquidity programs that w
ere implemented in response to the financial crisis, see www.federalreserve.gov/
monetarypolicy/bst_crisisresponse.htm on the Board's website. Return to text
7. Reserves were initially taken out of the banking system by not reinvesting pr
incipal payments from maturing securities and later by selling portions of secur
ities holdings. In September 2008, the Department of the Treasury announced the
temporary Supplementary Financing Program, in which the proceeds of a series of
Treasury bill auctions, separate from Treasury's routine borrowing, were maintai
ned in an account at the Federal Reserve Bank of New York. The funds in this acc
ount served to drain reserves from the banking system. Return to text
8. Consider the following policy rule: R(t) = R* + p(t) + 0.5[p(t)-p*]-2.0[U(t)U*], where R is the federal funds rate, R* is the longer-run normal value of the
federal funds rate adjusted for inflation, p is the four-quarter moving average
of core PCE inflation, p* is the FOMC's target for inflation (2 percent), U is
the unemployment rate, and U* is the longer-run normal rate of unemployment. Bas
ed on the medians of FOMC participants' latest longer-run projections, R* is app
roximately 1 percent and U* is about 4.8 percent. Accordingly, with the unemploy

ment rate climbing to 10 percent and core PCE inflation falling to 1 percent in
2009, this rule would have prescribed lowering the federal funds rate to minus 9
percent at the depths of the recession. In contrast, the standard Taylor rule,
which is half as responsive to movements in resource utilization, would have pre
scribed lowering the federal funds rate to minus 3-3/4 percent using the same es
timates for R* and U*. The more aggressive rule does a reasonably good job of ac
counting for movements in the federal funds rate in the decade prior to its fall
ing to its effective lower bound in late 2008, see David Reifschneider (2016), "
Gauging the Ability of the FOMC to Respond to Future Recessions (PDF)," Finance
and Economics Discussion Series 2016-068 (Washington: Board of Governors of the
Federal Reserve System, August). For more information on the standard Taylor rul
e, see John B. Taylor (1993), "Discretion versus Policy Rules in Practice," Carn
egie-Rochester Conference Series on Public Policy, vol. 39 (December), pp. 195-2
14. Return to text
9. Paying interest on reserves is a tool commonly used by central banks, includi
ng the Bank of England, the Bank of Japan, and the European Central Bank. Return
to text
10. Other tools that could help strengthen the floor under short-term interest r
ates but are not currently in use include the Term Deposit Facility and term rev
erse repurchase agreements. Return to text
11. Prior to the crisis, the Fed occasionally used forward guidance pertaining t
o the likely future path of interest rates, but that guidance was usually confin
ed to a relatively short time frame. Return to text
12. See, for instance, Joseph Gagnon, Matthew Raskin, Julie Remache, and Brian S
ack (2011), "The Financial Market Effects of the Federal Reserve's Large-Scale A
sset Purchases," Leaving the Board International Journal of Central Banking, vol
. 7 (March), pp. 3-43; and Stefania D'Amico, William English, David Lpez-Salido, a
nd Edward Nelson (2012), "The Federal Reserve's Large-Scale Asset Purchase Progr
ammes: Rationale and Effects," Economic Journal, vol. 122 (November), pp. F415-4
6. Moreover, the Federal Reserve's forward guidance and asset purchase policies
have been estimated to have helped lower unemployment and boost inflation; see E
ric M. Engen, Thomas Laubach, and David Reifschneider (2015), "The Macroeconomic
Effects of the Federal Reserve's Unconventional Monetary Policies," Finance and
Economics Discussion Series 2015-005 (Washington: Board of Governors of the Fed
eral Reserve System, January). Return to text
13. The FOMC's "Policy Normalization Principles and Plans" call for reducing the
Federal Reserve's securities holdings in a "gradual and predictable manner prim
arily by ceasing to reinvest repayments of principal on securities held in the [
System Open Market Account]" (Board of Governors of the Federal Reserve System (
2014), "Federal Reserve Issues FOMC Statement on Policy Normalization Principles
and Plans," press release, September 17, second bullet). Consistent with those
plans, the Federal Open Market Committee anticipates that it will maintain its c
urrent reinvestment strategy "until normalization of the level of the federal fu
nds rate is well under way" (for instance, see Board of Governors of the Federal
Reserve System (2015), "Federal Reserve Issues FOMC Statement," press release,
December 16, paragraph 5. Return to text
14. If the FOMC were to again increase the size of the balance sheet markedly in
response to a future recession, then the ability to pay interest on reserves co
uld be critical during the subsequent recovery period to help control short-term
interest rates while the balance sheet remains elevated. Beyond this motivation
for retaining IOER, the ability to pay interest on reserves could also be impor
tant to the operation of any special liquidity and credit facilities that might
be created to deal with systemic disruptions to the financial system during a fu
ture emergency. In particular, such facilities could significantly expand the su

pply of reserves, which would be problematic if the FOMC wished to keep short-te
rm interest rates from falling to zero. Return to text
15. In the Blue Chip Financial Indicators survey released on June 1, 2016, the c
onsensus forecast for the longer-run level of the federal funds rate was 3.2 per
cent. FOMC participants in June 2016 generally anticipated a slightly lower long
er-run level, in that the median of their individual forecasts was 3 percent (se
e table 1 of the June 2016 SEP, available at www.federalreserve.gov/monetarypoli
cy/fomcminutes20160615ep.htm). The latest long-run forecast from the Administrat
ion (www.whitehouse.gov/sites/default/files/omb/budget/fy2016/assets/16msr.pdf)
is also close to 3 percent, as was the projection made by the Congressional Budg
et Office earlier in the year (see www.cbo.gov/about/products/budget_economic_da
ta). Return to text
16. Updated estimates from the model developed by Laubach and Williams (2003) in
dicate that the real long-run neutral or "equilibrium" short-term interest rate
in the United States is currently about 2-1/2 percentage points lower than it wa
s on average in the 1980s and 1990s (see Thomas Laubach and John C. Williams (20
03), "Measuring the Natural Rate of Interest," Review of Economics and Statistic
s, vol. 85 (November), pp. 1063-70; updated estimates are available at www.frbsf
.org/economic-research/economists/john-williams/Laubach_Williams_updated_estimat
es.xlsx.) Leaving the Board In addition, Holston, Laubach, and Williams (2016) f
ind significant but somewhat smaller declines in equilibrium rates for the euro
area, Canada, and the United Kingdom (see Kathryn Holston, Thomas Laubach, and J
ohn C. Williams (2016), "Measuring the Natural Rate of Interest: International T
rends and Determinants," Working Paper 2016-11 (San Francisco: Federal Reserve B
ank of San Francisco, June), www.frbsf.org/economic-research/files/wp2016-11.pdf
). Leaving the Board Return to text
17. For a discussion of the possible role played by these factors in explaining
the current low level of interest rates in the United States and other advanced
economies, see Lawrence H. Summers (2014), "U.S. Economic Prospects: Secular Sta
gnation, Hysteresis, and the Zero Lower Bound," Business Economics, vol. 49 (Apr
il), pp. 65-73; Robert J. Gordon (2014), "The Demise of U.S. Economic Growth: Re
statement, Rebuttal, and Reflections," Leaving the Board NBER Working Paper 1989
5 (Cambridge, Mass.: National Bureau of Economic Research, February); and Ben S.
Bernanke (2015), "Why Are Interest Rates So Low, Part 2: Secular Stagnation," L
eaving the Board Ben Bernanke's Blog, blog post (Washington: Brookings Instituti
on, March 31). Return to text
18. For example, see James D. Hamilton, Ethan S. Harris, Jan Hatzius, and Kennet
h D. West (2015), "The Equilibrium Real Funds Rate: Past, Present, and Future,"
Leaving the Board NBER Working Paper 21476 (Cambridge, Mass.: National Bureau of
Economic Research, August); and Olivier Blanchard (2016), "Three Remarks on the
U.S. Treasury Yield Curve," Leaving the Board Realtime Economic Issues Watch (W
ashington: Peterson Institute for International Economics, June 22). Return to t
ext
19. FRB/US model simulations have several advantages for analyzing this issue. F
or one, the model's structure allows the public's expectations for interest rate
s, inflation, and other factors to take full account of the implications of the
effective lower bound on nominal interest rates, changes in future monetary poli
cy as signaled by forward guidance, and asset purchases. In addition, the model
incorporates the low responsiveness of inflation to movements in resource utiliz
ation seen in recent years as well as the effects of asset purchases on term pre
miums, and thus a variety of longer-term interest rates, equity prices, and the
foreign exchange value of the dollar. For a further discussion about the advanta
ges (and possible disadvantages) of using the FRB/US model to study this issue,
see Reifschneider, "Gauging the Ability of the FOMC to Respond to Future Recessi
ons," in note 8. Return to text

20. The aggressive rule is R(t) = 1.0 + p(t) + 0.5 [p(t)-2] - 2.0 [4.8 - U(t)],
where R is the federal funds rate, p is the four-quarter moving average of core
PCE inflation, and U is the unemployment rate. Note that baseline values of the
equilibrium real rate, the natural rate of unemployment, and the target rate of
inflation used in the simulation analysis--1.0 percent, 4.8 percent, and 2.0 per
cent, respectively--are consistent with the medians of the latest long-run proje
ctions of individual FOMC participants. As discussed by Taylor (1999), this rule
appears to do a good job in stabilizing real activity and inflation in a wide r
ange of economic models (see John B. Taylor (1999), "Introduction," in John B. T
aylor, ed., Monetary Policy Rules (Chicago: University of Chicago Press), pp. 114). Return to text
21. The forward guidance is provided at the start of the recession and has three
components. First, the federal funds rate will be lowered to zero more quickly
than prescribed by the rule. Second, the federal funds rate will remain at zero
as long as the unemployment rate is greater than 5 percent. And, finally, that a
fter the initial increase in the federal funds rate, policymakers will proceed g
radually in returning to the prescriptions of the policy rule. Return to text
22. As shown in figure 2, the 10-year Treasury yield in the simulation starts ou
t at just over 4 percent, well below its level pre-crisis, suggesting that there
may be less room to push down long-term interest rates in the future than in th
e past. Another potential source of overstatement could be the FRB/US assumption
that changes in long-term interest rates, whether driven by shifts in term prem
iums or shifts in the expected path of short-term interest rates, have the same
influence on real activity, as there is some empirical evidence that the estimat
ed sensitivity of spending to movements in term premiums alone may be relatively
small; see Michael T. Kiley (2014), "The Aggregate Demand Effects of Short- and
Long-Term Interest Rates," Leaving the Board International Journal of Central B
anking, vol. 10 (December), pp. 69-104. On the other hand, the effectiveness of
forward guidance in the FRB/US model is materially less than it is in some other
models, implying that the FRB/US simulation results could potentially understat
e the stimulus provided by the announcement of a lower-for-longer policy. See He
ss Chung (2015), "The Effects of Forward Guidance in Three Macro Models," FEDS N
otes (Washington: Board of Governors of the Federal Reserve System, February 26)
. Return to text
23. In principle, the federal funds rate in the longer run could also turn out t
o be lower than currently predicted if inflation were to remain persistently bel
ow 2 percent. However, because a higher rate of inflation can arguably be achiev
ed over time through a sufficiently tight labor market, this risk seems low to m
e as long as the Federal Reserve is committed to achieving its inflation objecti
ve. Return to text
24. In the simulations reported by Reifschneider, "Gauging the Ability of the FO
MC to Respond to Future Recessions," in note 8, overcoming the effects of the ze
ro lower bound during a severe recession would require about $4 trillion in asse
t purchases and pledging to stay low for even longer if the average future level
of the federal funds rate is only 2 percent. Return to text
25. For further discussion of ways to enhance the effectiveness of fiscal policy
in stabilizing the economy, see Xavier Debrun and Radhicka Kapoor (2010), "Fisc
al Policy and Macroeconomic Stability: Automatic Stabilizers Work, Always and Ev
erywhere (PDF)," Leaving the Board IMF Working Paper WP/10/111 (Washington: Inte
rnational Monetary Fund, May); Antonio Fats and Ilian Mihov (2012), "Fiscal Policy
as a Stabilization Tool," B.E. Journal of Macroeconomics, vol. 12 (October), pp
. 1-66; International Monetary Fund (2015), "Can Fiscal Policy Stabilize Output?
(PDF)" Leaving the Board chapter 2 in Fiscal Monitor (Washington: IMF, April),
pp. 21-48; and Alisdair McKay and Ricardo Reis (2016), "The Role of Automatic St

abilizers in the U.S. Business Cycle," Econometrica, vol. 84 (January), pp. 14194. Return to text